Level 3 Weighs Its Options
The knee-jerk reaction: Hey, it must be another telecom for sale! But many observers are asking if anyone is really looking to buy a Tier 2 player with a limited network, mostly wholesale business, and huge amounts of debt.
Even as Qwest Communications International Inc. (NYSE: Q) makes a second push for MCI Inc. (Nasdaq: MCIP), speculation abounds that the Midwestern RBOC will make a play for Level 3 if it loses its bid for the long-distance carrier (see Qwest to MCI: 'Pretty Please?'). While many believe that Qwest has a good chance of convincing MCI shareholders that it has a better offer, others believe that Verizon Communications Inc.’s (NYSE: VZ) superior market cap and lower debt obligations make it a more attractive partner for MCI (see Qwest Plans New Bid for MCI and Qwest Filing Details $8B MCI Bid).
Forrester Research Inc. analyst Lisa Pierce says that if Qwest loses its bid for MCI, its possible merger partners become somewhat limited. While Level 3 is an option, it wouldn’t give them the reach that MCI’s network would. “Barring a successful outcome with MCI, Qwest’s strategy is to look at picking up smaller regional players,” she says. “Level 3 is a possibility, but it is mainly a wholesaler, which doesn’t give them the enterprise reach MCI would.” Mark Lutkowitz, a principal at Telecom Pragmatics Inc., believes the end result of all the carrier M&A activity is that we’ll end up with two Ma Bells -- Verizon and SBC Communications Inc. (NYSE: SBC) -- and that there may not be room for Level 3. “We believe that ultimately SBC will pick up Qwest or BellSouth, and Verizon will grab whoever’s left,” he says. “One option for Level 3 is to get together with other IXCs like WilTel, but that still doesn’t solve the problem of local access.”
And evidence is mounting that Level 3 is looking for a buyer. The company announced earlier this week that it would sell more than $880 million in convertible notes and has removed its stockholder rights plan (see Level 3 Kills Stockholder Rights Plan). By removing the stockholder rights plan –- also known as a “poison pill” designed to make the company less attractive to suitors –- Level 3 could be signaling to potential buyers that it is open to acquisition offers.
The convertible notes will raise some needed cash to shore up its finances. But a look at the company’s balance sheet shows what a scary situation that is. In the last year, the company has been swiftly burning through its cash, dropping from $1.9 billion in current assets at the end of 2003, to $1.4 billion at the close of of 2004, according to public filings. And while the company’s liabilities have decreased, from $8.1 billion to $7.5 billion during that same period, it's still burning through cash. Add to that the fact their book value had by the end of 2004 gone negative, and Level 3’s acquisition attractiveness drops a few notches.
Many analysts see the news that Level 3 is raising more cash as an important announcement, as it gives the company financial flexibility to continue to grow strategically. “They need to demonstrate to investors that liquidity is not an issue going forward,” says James Lee, a research analyst at DE Investment Research. "What they’re trying to do is to create a buzz with all the current M&A activity that is going on in the marketplace.”
While the company’s recent announcements may cause some potential suitors to take a closer look at the company, a deal probably won’t happen until the company improves profitability and cuts its debt. “Level 3 management has to do what AT&T and MCI have done to attract buyers,” Lee says. “Cutting costs, getting out of non-profitable businesses, and cutting debt to the point where it would be easier for a buyer to swallow.” (See SBC to Buy AT&T for $16B and Verizon Wins Tussle for MCI.)
At the end of the third quarter of 2004, Level 3 held $5.06 billion in debt. With the new offering of convertible notes, analyst Lee points out its debt will now total $6 billion.
Calls to Level 3 for comment regarding its long-term plans were not returned.
But Level 3 has options for improving its balance sheet, which include getting rid of non-core businesses, such as its coal-mining operation, or selling off some of its 68 data centers. “Once their balance sheet is clean and VOIP becomes a more important market, then they could become a more attractive candidate for acquisition,” says Lee. “But I still believe that any acquisition is at least 18 months away.”
— Chris Somerville, Senior Editor, Next-Generation Services